Markets Grudgingly Accept Imminent Tapering

In this upside-down financial world where investors view positive economic data as bad news it’s entirely possible Federal Reserve policy makers are pleased with the recent spate of stock market losses.

In fact, the market selloffs this week could be viewed as part of a broader Fed strategy for transitioning investors away from years of central bank largesse via its easy-money stimulus policies.

Here’s why: the Fed learned its lesson in June when Chairman Ben Bernanke dropped his hypothetical bombshell, confirming that the Fed may begin phasing out its $85 billion a month bond purchase program known as quantitative easing “later this year.”

Investors heard “later this year” as September, and promptly sent stock markets into a nose dive and drove bond yields to their highest levels in years.

Now it seems increasingly likely that the Fed is ready to announce at its September 16 meeting that bond purchases will in fact be scaled back in response to recent economic data that show the U.S. economy is gradually strengthening.

In an effort to avoid a repeat of June’s panic-driven selloff, Fed policy makers have been telegraphing their intentions almost daily so that the markets can adjust gradually rather than reacting all at once should so-called tapering become a reality next month.

After months of mixed messages from the central bank over when and how stimulus would eventually be scaled back, a cacophony that confused markets time and again, the Fed seems to have finally honed in on a unified message – tapering is imminent.

In speeches over the past two weeks Fed presidents from Atlanta, Cleveland, and Chicago have all taken pains to convey that message. Chicago Fed President Charles Evans specifically told reporters he   “wouldn’t rule out” September as a starting point for the beginning-of-the-end of Fed stimulus.

Avoiding a Full-Blown Tantrum

Markets listened closely to the messages and then responded this week when positive economic data seemed to validate the Fed’s position that tapering should begin sooner rather than later.

Weekly unemployment claims reported Thursday by the Labor Department were the lowest since 2007. In response, the Dow Jones Industrial average fell 225 points on the news, a day after losing 113 points. Markets were flat on Friday as investors regrouped following the two-day selloff.

Thursday’s selloff was directly tied to positive news from the U.S. labor markets, the sector Fed policy makers have been targeting for improvement since initiating a third round of bond purchases last year. Other positive data reported during the past two weeks have helped push the Dow down 3.4%, the steepest 2-week drop in 9 months. Still, the Dow is up about 15% on the year.

Current conventional wisdom holds that it will take a truly awful August jobs report to alter the Fed’s plan to begin tapering in September. After nearly five years of quantitative easing and historically low interest rates, monetary policies that have fueled a lengthy bull market, investors are gradually coming to grips with the end of stimulus.

“How many times have you heard over the last few years that U.S. stocks were the best show in town because the Federal Reserve was pushing liquidity into the system?” asked Nick Colas, chief market strategist at ConvergEx Group, a global brokerage company based in New York.

“OK – that overarching narrative is coming to an end with talk of ‘Tapering’ in September. Yes, I know the Fed isn’t abandoning the financial system just yet.  But like so many Americans, their job in supporting capital markets will be shifting to a part-time engagement,” Colas said in a note to clients.

The point is that markets will undoubtedly continue to sulk each time positive economic data makes it clear that the end to easy-money is drawing near. But a relatively measured response drawn out over many weeks is far preferable to a full-blown tantrum on September 16, when all the anxious speculation is likely to become a reality.